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Friday, October 29, 2010

Expectations...fulfilled?

There's a lot of news coming out next week, both mid-term elections and the Federal Reserve meeting to announce the much-anticipated launch of QE2 (quantitative easing, round 2). 

The key question for markets is: how much of the news is already factored into prices?

This points to one of the most difficult concepts for investors to grasp--prices do not reflect current or past information, but investor expectations.

Many investors are surprised when good news comes out--"company earnings grew 50%"--only to see a stock's price tank.  Why?  Because market price already reflected greater than 50% growth. 

Or, they're surprised to see bad news--"the economy shrank by 2%"--lead to a jump in the stock market.  Why?  Prices reflected a more than 2% economic decline. 

Prices, whether for bonds, stocks, commodities or currencies, reflect investor expectations.  Prices move up when actual news is better than expectations and down when it's worse than expectations.

Which raises the question in my title: will news next week exceed, fulfill or disappoint expectations?  If fulfilled, prices won't move much; if exceeded, prices will jump; if disappointing, prices are likely to fall.

Right now, investors clearly expect the Federal Reserve to announce a quantitative easing package that is favorable to bonds, stocks and commodities and bad for the dollar.  Will that announcement fulfill, exceed or disappoint?  Markets seem too optimistic to me, but as the old Wall Street saying goes: "don't fight the Fed."  On the other hand, is the Federal Reserve printing dollars really a cause for stocks and bonds to appreciate?  Something to think about.

Investors currently expect Republicans to take back the House of Representatives and make gains, if not restore a majority, in the Senate.  Do market prices already reflect that expectation, or will they be disappointed?  For that matter, are market participants correctly reflecting what will actually happen if their expectations are fulfilled?  Will Republicans cutting spending be good or bad for stock prices in the short run?  Something to ponder.

The S&P 500 is selling for around $1180 right now, reflecting an expectation of 14% per share earnings growth over the next year.  With the economy likely to grow at around 2% and profit margins at cyclical highs, is overly optimistic earnings growth expected?  What will happen to stock prices if those expectations go unfulfilled?

In the long run, investing success is all about paying the right price for an asset.  In the short run (which is what Wall Street does with less than 6 month holding periods), investing success is all about guessing investor expectations.  For those focused on the long run, next week is a non-issue.  For those focused on the short run, next week will be a nail-biter.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Friday, October 22, 2010

Buy the rumor, sell the news

An old saying on Wall Street is "buy the rumor, sell the news."  It means that markets tend to react to rumors by bidding up prices and then selling (pushing prices back down) when the news actually hits.

Unless you've never read my blog before, you know that I don't tend to pay much attention so this short-term, trader-oriented approach.  However, I am sometimes so completely baffled by the way markets react to news and rumors that I can't help but remember the old saying.

Since late August, the stock market has rallied strongly, as have commodities and gold.  Over the same period, the dollar has tanked.  Since spring, the bond market has rallied strongly, too.  What's going on?

In my opinion, bonds have rallied strongly because economic numbers have been weak.  Unemployment remains high, GDP growth has slowed, the ECRI weekly leading index has tanked (but is recovering), and new unemployment claims have stayed stubbornly over 450,000.  I think bond holders are forecasting a sustained slowdown or recession and continued deflation.  This should not be good news for stocks, commodities and gold, and should be good for the dollar.  So, why is the opposite happening?

In short, the answer is that Federal Reserve board members, since late August, have been strongly hinting that the economy is so weak it may need another round of "quantitative easing."  For those of you blissfully ignorant of what the heck quantitative easing is, it's economic jargon for central bankers printing money (without physical backing).  In this case, they will print dollars, creating money from nothing, and use those dollars to purchase government bonds on the open market.

Why is that good for every market except the dollar?  Good question.  It's good for bonds, because the government will buy bonds in large amounts.  It's good for stocks because this will supposedly goose the economy.  It's good for commodities and gold but bad for the dollar because it means inflation.  If you're confused now, good for you.

Let me summarize: the U.S. economy is doing so badly that the Federal Reserve is going to try to intentionally create inflation.  Somehow that's good for stocks, bonds, commodities and gold, but not the dollar?  That can't be so.  Inflation may be good for commodities and gold and bad for the dollar, but it's definitely not good for stocks and bonds.  Something's amiss.

Which brings me back to: buy the rumor, sell the news.  The Fed has not officially announced its second round (the first was in 2008) of quantitative easing (colorfully dubbed QE2 by market watchers).  That is most likely to occur in early November.

I think that markets are buying the rumor of QE2 and may very well sell the news come early November.  Markets may be particularly unhappy if the news of QE2 doesn't meet its grand expectations. 

In the long run, bad economic news can't be good for stocks and commodities.  If the Fed does manage to create inflation with QE2 (which is not a given), it won't be good for bonds, stocks or the dollar. 

How can bad news about the economy be good news for markets?  In the long run, it can't be.

My ability to time the market is somewhere around zero, so take what I have to say with a big grain of salt.  I'm not buying this rumor, nor selling the news, but caution is highly recommended.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Friday, October 08, 2010

Mixed up markets

When most people think of "the market," they think of the stock market.  But, there are other markets that are equally or more important to pay attention to.

For example, bond and currency markets are bigger than stock markets.  Commodity markets are important, too, but most people ignore them.

Why are other markets important, you may ask?  Because they frequently bring warnings of contradictory premises held by different participants in each specific market.

In a normal state of affairs, currencies and gold should move in opposite directions.  That's what's happening right now, especially with gold flying high and the U.S. dollar crashing.  All good there.

Normally, commodities move opposite the dollar.  Commodities have been soaring and the U.S. dollar is tanking, so everything looks as it should there, too.

Next, we come to bonds.  Bonds and commodities normally move opposite each other, and here we run into our first contradiction.  Commodities are soaring and bonds are climbing, too.  The first indicates inflation and fast economic growth and the second indicates deflation and slow or declining economic growth.  Both markets can't be right.

Furthermore, commodities and stocks usually move opposite each other, which is just another way of saying bonds and stocks tend to move together.  Climbing commodities indicates inflation and high interest rates (lower bond prices) which both tend to be bad for stocks.

Don't get me wrong, I'm not saying these relationships exist at all times and all places.  But, when I see markets seeming to indicate different opinions, I take notice.  It means markets are mixed up and one will turn out to be right and the other wrong.

Things are pretty mixed up right now.  The dollar is sinking, commodities are climbing, as are stocks and bonds. 

The dollar is sinking because the Fed is going to print money to try to further revive our flagging U.S. economy.  That means a lower U.S. dollar, higher inflation, and rising commodities and gold.  So far, so good.

But, a lower dollar, higher inflation and rising commodities is inconsistent with high bond and stock prices.  High inflation is bad for bonds and stocks.  That contradiction must be resolved.

To further muddy the waters, rising bond prices usually correspond with higher stock prices, but not super high bond prices.  Super high bond prices means very low bond yields, which tends to indicate low growth, deflation and economic stagnation.  And, that's usually NOT a recipe for higher stock prices.  As illustration, Japan's bond prices have gone up for 20 years while its stock market has lost 75% of its value. 

Bonds are indicating slow or negative growth and stocks are rallying, and that doesn't make sense.  Bond markets are right more often that stock markets, so the on-going stock rally might be in danger. 

High gold and commodity prices and a falling U.S. dollar should mean lower bond prices and high bond yields (a.k.a. inflation).  Once again, this contradiction must be resolved.

Over time, all markets will sync back up again.  Either bonds and stocks will tank and the dollar will continue to fall; or, commodities and gold will tank, the dollar will rally, and stocks and bonds will continue to rise.  It may take time, but markets will re-achieve consistentency.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Friday, October 01, 2010

Competitive Devaluation

The issue I fear most from an economic, political and geo-political standpoint is the huge debt overhang of the largest developed economies of the world: U.S., Europe, U.K. and Japan.

Solving this nightmare is not just an issue for the developed world, either, because it also greatly impacts the developing world (especially Brazil, Russia, China and India).

In order for the developed economies to pay off their debt, they must either grow their way out of debt or print money to inflate away the debt they owe. 

Growth would be the best and most honorable way to solve the problem, but growth in developed economies is inhibited by high debt loads (which lead to slower growth) and huge social programs (Medicare, Medicaid, Social Security and their equivalents in the other developed economies).

I'm sorry to admit it, but democracies have never successfully voted away social programs, and I don't think they will this time, either.

That leaves inflation.

But, inflation is a nasty solution to debt problems. 

From an economic standpoint inflation is tough to put back in the bottle once you let it out.  If you think the Federal Reserve or any other central bank has a dial they can turn to 3%, 5%, or any other specific level of inflation, I'm sorry to let you know that smurfs aren't real, either.

Inflation crimps a whole economy as everyone--from employees to employers, from government bureaucrats to private companies--becomes bogged down in trying to figure out wages, salaries, costs, prices, tax rates, etc.  No high inflation economy runs smoothly and efficiently.

The political and geo-political stage started to ripple this week as the U.S. Congress is trying to pressure China into revaluing their currency and Brazil's Finance Minister remarked that an "international currency war" is taking place as governments manipulate their currencies to improve their export effectiveness.  Japan recently announced they will be active in currency markets to prevent the price of the yen from rising too much and becoming uncompetitive in global markets.  These trends will result in the beggar thy neighbor problem I highlighted in a previous blog.

This competitive devaluation process is a race to the bottom and has an ugly history.  In the past it's led to world war and economic collapse.  I wish I could say these were idle fears, but they are not.

The U.S. economy currently has low inflation, and that looks set to last until the private market works down its bad debt problem (which I think will happen over the next 3 - 5 years).  Some believe the U.S. economy will experience the low inflation, deflation and low interest rates of Japan over the last 20 years.  In that environment, cash and bonds will do very well.

Never say never, but I doubt we'll experience what Japan did.  In that case, inflation is the more likely threat, and that's not a good scenario for owning a lot of bonds or cash.

The competitive devaluation that's occurring does not need to continue, so my fears may be unjustified.  Even if they are justified, the end-game is unlikely to play out soon, but over the next decade.  Hope is not a strategy, so I'm hoping for the best while preparing for the worst.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.